Efficient Market Theory

Jan 21, 2019

Efficient Market Theory: A Contradiction of Terms

Table of Contents

Table of Contents i

Abstract 2

Discussion 1-1

References A-1

Abstract

According to the Efficient Market Theory, it should be extremely difficult for an investor to develop a "system" that consistently selects stocks that exhibit higher than normal returns over a period of time. It should also not be possible for a company to "cook the books" to misrepresent the value of stocks and bonds. An analysis of current literature, however, indicates that companies can and do "beat the system" and manipulate information to make stocks appear to perform above average. An understanding of the underlying inefficient "human" factors in the market equation is necessary in order to account for the flaw in Efficient Market Theory.

Efficient Market Theory: A Contradiction of Terms

Efficient Market Theory (EMT) is based on the premise that, given the efficiency of information technology and market dynamics, the value of the normal investment stock at any given time accurately reflects the real value of that stock. The price for a stock reflects its actual underlying value, financial managers cannot time stock and bond sales to take advantage of "insider" information, sales of stocks and bonds will not depress prices, and companies cannot "cook the books" to artificially manipulate stock and bond prices. However, information technology and market dynamics are based upon the workings of ordinary people and diverse organizations, neither of which are arguably efficient nor consistent. Therefore, we have the basic contradiction of EMT: How can a theory based on objective mechanical efficiency hold up when applied to subjective human inefficiency?

As a case in point, America Online (AOL) offers a classic example of how investors can be misled by a company that uses the market system against itself. AOL, up until early November of this year, used an accounting system that effectively "cooked their books" and provided misleading figures on the company's performance. Instead of accounting for its promotion expenses and costs as a regular expense, as normal companies do, AOL spread them over two years. This let AOL report annual profits based on revenue figures derived from denying actual expenses (as cited in Newsweek, November 11 edition).

By deferring those costs, AOL over the years reported profits $385 million greater than they would otherwise have been. The company then used these non-existent profits to promote itself as a money-making opportunity for both stockholders and potential investors, artificially increasing its stock prices. This accounting practice is perfectly legal, but the information was kept private for over two years. The company has recently announced that, effective immediately, promotion expenses will be charged to earnings as the expenses are incurred, the way a normal company does. AOL will also take a one-time special charge of $385 million for the "deferred" promotion costs.

This effectively negated all profits reported by the company over the years and put them in a negative net cash flow situation. As a result, AOL's stock is currently listed at 35 ¼, down from a high of 71 in May. This example clearly outlines a major flaw in Efficient Market Theory: If EMT relies heavily on information as the basis for determining market value, what happens if the information is manipulated? As a counterpoint, the clear assertion in the Newsweek article is that most normal companies do not use such accounting practices, however legal, to falsely report superior performance. EMT states:

Fundamental analysis cannot produce investment recommendations that will enable an investor consistently to outperform a buy-and-hold strategy in managing a portfolio (Malkiel, 1990).

The corollary of the theory must also then be true. An investor cannot be hurt by the market because the stock value of a poor or overvalued performer already reflects that fact in its price. The available information would indicate to investors that certain stocks are overvalued and subject to rapid decline. The availability of public information did finally force AOL into disclosing the ruse and changing its accounting practices, and coincidentally, lower the stock value to its true worth.

The argument that Efficient Market Theory was working in AOL's case is that the investors were protected from precipitous loss because the system adjusted the stock price to reflect the actual value of AOL stock. The previously high price did indicate the value of the stock based on the accounting practices then in effect, however misleading they may have been. At the moment that the company decided to change the accounting practices, the value of the stock then was corrected to the actual lower value. This could, reasonably, be viewed as a repudiation of EMT.